Chapter -4 [Compatibility Mode](1).Pdf

Chapter 4 Financial Statement Analysis What is Financial Statement Analysis?  FSA is the process of identifying financial strengths & weaknesses of the firm by properly establishing relationship b/n[.]

Chapter 4

Financial Statement Analysis

What is Financial Statement Analysis?

 FSA is the process of identifying financial strengths & weaknesses of the firm by properly establishing

relationship b/n the items of the balance sheet & the

income statement

 There are various techniques used to analyze financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, & ratios analysis

 Financial statements are prepared to meet

external reporting obligations & also for decision making purposes

 But the information provided in the financial

statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone

 However, the information provided in the

financial statements is of immense use in making decisions through FSA

Sources of FSA

An annual report of a company usually contains:

A. Financial statements

B. Notes to the financial statements

C. A summary of accounting methods used

D. Management discussions

E. An auditor’s report

F. Comparative financial data for 5 to 10 years.All these documents can be the source of financial statement analysis

Horizontal and Vertical Analysis

Horizontal (Trend) Analysis

 Comparison of two or more year's financial

data is known as HA, or trend analysis

 HA is facilitated by showing changes

between years in both value (dolla/birr) and percentage form

 Horizontal analysis of financial statements

can also be carried out by computing trend percentages

 Trend percentage states several years' financial data in terms of a base year

 The base year equals 100%, with all other years stated in some percentage of this base

 Therefore, the changes in financial statements from a base year to the subsequent years are expressed as a trend percentage to show the

extent & direction of changes

2005 2004 DifferenceSales $41,500 $37,850 $3,650

Horizontal Analysis-Example

Sales $41,500 $37,850 $3,650

3,650 ÷ 37,850 = 0.0964, or 9.6%

Trend Percentages - Example

…are computed by selecting a base year whose amounts are set equal to 100%

The amounts of each following year are expressed

as a percentage of the base amount

Trend % = Any year ÷ Base year

Trend Percentages - Example

Year 2005 2004 2003Revenues $27,611 $24,215 $21,718Cost of sales 15,318 14,709 13,049Gross profit 12,293 9,506 8,669

Gross profit 12,293 9,506 8,669

2003 is the base year.

What are the trend percentages?

Trend Percentages - Example

 Each item is stated as a percentage of some

total of which that item is a part

 Key financial changes & trends can be

highlighted by the use of common size statements

Vertical Analysis

…compares each item in a financial

statement to a base number set to 100% Every item on the financial statement is

then reported as a percentage of that base.

Common-size Statements

 On the income statement, each item is

expressed as a percentage of net sales.

 On the balance sheet, the common size is the total on each side of the accounting

the total on each side of the accounting equation

 Common-size statements are used to

compare one company to other, and to the industry average

Common-size Statements-example

MCILucent Technologies

 Cost of goods sold

 Income tax

 Operating expenses

 Net income

2 Ratio Analysis

 Ratios are the most powerful tool of FSA

 Ratios simply mean one number expressed in terms of another

 A ratio is a statistical yardstick by means of which relationship b/n two or various figures can be compared and measured

 Ratios show how one number is related to another

long-4 Measuring profitability (Profitability ratios)

5 Analyzing stock as an investment (Market Value ratios).

 Following are the most commonly liquidity ratios:

 Current Ratio

 Liquid/Acid Test/Quick Ratio

Stylistic Furniture Example (Year 2005)

Total operating expenses 244,000

Total operating expenses 244,000

Stylistic Furniture Example

Stylistic Furniture

Current liabilities:

Notes payable $ 42,000 $27,000Accounts payable 73,000 68,000

Accounts payable 73,000 68,000Accrued liabilities 27,000 31,000Total current liabilities 142,000 126,000Long-term debt 289,000 198,000Total liabilities $431,000 $324,000

Stylistic Furniture

Stockholders’ Equity 2005 2004Common stock, no par $186,000 $186,000Retained earnings 170,000 134,000

Retained earnings 170,000 134,000Total stockholders’ equity $356,000 $320,000Total liabilities and

stockholders’ equity $787,000 $644,000

The current ratio measures the company’s

ability to pay current liabilities with current

assets

Liquidity measures

Current ratio = Total current assets ÷ Total current liabilities

Liquidity measure

Current ratio: CA/CL

 2004: $236,000 ÷ $126,000 = 1.87

 2005: $262,000 ÷ $142,000 = 1.85

 The industry average is 1.50

 The current ratio decreased slightly during 2005

Liquidity measure

The acid-test ratio shows the company’s

ability to pay all current liabilities

if they come due immediately

Acid-test ratio =(Cash + STIs+ Net current receivables) ÷ Total current liabilities

Quick Assets = Current Assets – (Inventories & Prepaid Assets) ÷

Total Current Liability

Measuring Ability to Pay Current Liabilities

 Acid-test ratio: QA/CL

 The industry average is 0.40

 The company’s acid-test ratio has improved considerablyduring 2005

Activity Ratios

 Activity ratios are calculated to measure the efficiency with which the resources of a firm have been utilized

 These ratios are also called turnover ratios b/c

they indicate the speed with which assets are being turned over into sales and later into cash.

 Following are some of the activity ratios:

- Inventory turnover ratio

- Receivables turnover ratio

- Average collection period

Inventory turnover ratio is a measure of the

number of times the average level of inventory

is sold during a year

Measuring Ability to Sell Inventory

Inventory turnover = CGS÷ Average inventoryAverage Inventories = (Beginning Inventories

+ Ending Inventories)/2

Measuring Ability to Sell Inventory

Stylistics' inventory turnover:

 2005: $513,000 ÷ $112,000 = 4.58

 The industry average is 3.4

 A high number indicates the entity’s ability to quickly sell inventory

Accounts receivable turnover:

is measures a entity’s ability to collectcash from credit customers

Measuring Ability to Collect Receivables

Accounts receivable turnover =Net credit sales ÷ Average accounts receivable

Ability to Collect Receivables

A/R Turnover:

 2005: $858,000 ÷ $99,500 = 8.62

timesThe industry average is 51 times

 The industry average is 51 times

 Stylistics’ receivable turnover is much

lower than the industry average

 The company is a home-town store

that sells to local people who tend to pay their bills over a lengthy period of time

Measuring Ability to Collect Receivables

Days’ sales in receivable ratio measures howmany day’s sales remain in Accounts Receivable

One day’s sales = Net sales ÷ 365 days

Days’ sales in Accounts Receivable =Average net Accounts Receivable ÷ One day’s sales

Ability to Collect Receivables

Days’ sales in Accounts Receivable for 2005:One day’s sales:

 $858,000 ÷ 365 = $2,351Days’ sales in A/Receivable:

 $99,500 ÷ $2,351 = 42 days

 The industry average is 7 days

Measuring ability to pay short-term and long-term

debt (Leverage ratios)

 Long term solvency or leverage ratios convey an entity’s ability to meet the interest costs & payment schedules of its long term obligations

 Following are some of the most important

long-term solvency or leverage ratios

o Debt Ratio

o Times-Interest-earned (Coverage ratio)

Ability to Pay Debt

The debt ratio indicates the proportion

of assets financed with debt

Debt ratio = Total liabilities ÷ Total assets

Ability to Pay Debt

Debt ratio: TL/TA

2004

 $324,000 ÷ $644,000 = 0.50

2005

 $431,000 ÷ $787,000 = 0.55

 The industry average is 0.64

Stylistic Furniture expanded operations during 2005 by financing through borrowing

Ability to Pay Debt

Interest Coverage Ratio (Times-Interest-Earned

Ratio) measures the number of times

operating income can cover interest expense

Interest Coverage Ratio (Times-interest-earned)

= Earning before interest and tax (EBIT) ÷ Interest expense

Ability to Pay Debt

 The industry average is 2.80

 The company’s interest coverage ratio increased

in 2005

 This is a favorable sign

Profitability (Profitability Ratios)

 Profitability ratios measure the overall performance & effectiveness of the business entity

 Some profitability ratios are:

- Rate of return on net sales (ROS)

- Rate of return on total assets (ROA)

- Rate of return on equity (ROE)

- Earnings per share of common stock

Rate of return on net sales shows the

percentage of each birr of sales earned asnet income

Rate of return on net sales = Net income

÷ Net sales

 The industry average is 0.008.

 The increase is significant in itself & also b/c it is much better than the industry average

Measuring Profitability

Rate of return on total assets measures

how profitably a company uses its assets

Rate of return on total assets =

(Net income + interest expense) ÷ Average total assetsi.e., operating income to average total assets is

Usually used to compute return on total assets

Measuring Profitability

Stylistics’ rate of return on total assets for 2005:

 ($48,000 + $24,000) ÷ $715,500 = 0.101

 The industry average is 0.078

 How does Stylistics’ compare to the industry?

 Very favorably

Rate of return on common stockholders’ equity

Measuring Profitability

Common equity includes additional paid-in

capital on common stock & retained earnings

Rate of return on common stockholders’ equity

= (Net income – preferred dividends)

÷ Average common stockholders’ equity

Measuring Profitability

Earnings per share of common stock

= (Net income – Preferred dividends)

÷ Number of shares of common stock

outstanding

Capital Market Ratios

 Relate investors’ expectations about the company’s

performance and financial conditions

 Following are the most important market value of investment ratios:

- Price/earning ratio

- Dividend yield

- Dividend per share of common stock -Book value per share of common stock

Price- Earning Ratio

PER = Current Market Price per Share of Common Stock ÷ earning per share of common stock

Analyzing Stock as an Investment

Price/earning ratio is the ratio of market price per share to earnings per share

2004

 $35 ÷ $2.60 = 13.52005

 $60 ÷ $4.80 = 12.5

 Given Stylistic Furniture’s 2005 P/E ratio of 12.5, we would say that the company’s stock is selling at 12.5 times earnings

Analyzing Stock as an Investment

Dividend yield shows the percentage of a

stock’s market value returned as dividends to

stockholders each period

Dividend Yield = Dividend per share of common (preferred) stock ÷ Market price per share

of common (preferred) stock

Analyzing Stock as an Investment

Dividend yield on Stylistics’ common stock:

2004

 $1.00 ÷ $35.00 = 0.029 (2.9%)2005

 $1.20 ÷ $60.00 = 0.020 (2%)

 An investor who buys Stylistics’ Furniture

common stock for $60 can expect to receive 2%

of the return on its investment annually in the form of cash dividends

Analyzing Stock as an Investment

Book value per share of common stock

= (Total stockholders’ equity – Preferred equity)

÷ Number of shares of common stock outstanding

Analyzing Stock as an Investment

Book value per share of Stylistics’ common stock:2004

 ($320,000 – $0) ÷ 10,000 = $32.002005

 ($356,000 – $0) ÷ 10,000 = $35.60

Advantages of FAS

 The major benefit is that the investors get

enough idea to decide about the investments of their funds in the specific company

 FSA can help FSA can help government agencies government agencies to analyze to analyze the taxation that is due to a given business e